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How Long Will the Mortgage Bonanza Last?

Mortgage banking profitability soared to record levels in the third quarter, but some industry analysts say the boom may begin to taper off in 2013.

The surge in mortgage banking income during 2012 came from increased secondary marketing gains as the spread between primary market rates and yields on agency mortgage-backed securities widened to historic levels.

The most widely cited data on primary-secondary spreads show the spread widened from about 50 basis points to 100 bps in early 2009, and then spiked to 150 bps in the third quarter after the Federal Reserve announced its expanded support for the agency MBS market, according to a background paper prepared for the Fed last month.

“The high spread results in wide gain-on-sale margins for mortgage originators, and when combined with strong refinance volumes, has allowed originators to record strong mortgage-banking income over the past several quarters,” said Moody’s Investors Service. But record profits for lenders may be thwarting the main intent of the Fed’s new MBS purchase program, which was to encourage lenders to offer lower rates to refinance and purchase-mortgage borrowers, the rating service noted.

Regulators are applying pressure on banks to lower mortgage rates, Moody’s said. “Such pressure is credit negative for originators such as Wells Fargo, JPMorgan Chase and U.S. Bank because lower pricing for home loans – a likely outcome of the regulatory jawboning – would reduce their overall net revenues,” Moody’s noted.

Other analysts say record mortgage banking income should continue in 2013 despite any regulatory pressure. “Mortgage banking should continue record profitability,” according to a 2013 outlook from FBR Capital Markets.

Refinance activity is likely to remain strong in the near term thanks to low mortgage rates and government initiatives such as the Home Affordable Refinance Program, said FBR, which predicted a $2 trillion mortgage origination market in 2013.

HARP and capacity constraints – or pricing power – may be the most important factors in sustaining hefty secondary market gains, according to the Fed briefing paper that estimated the value of an originated mortgage, rather than just the primary-secondary spread. One of the key findings was that originator profits and unmeasured costs, or OPUC, jumped to over $4 per $100 of loan amount in early 2009 and then spiked to over $5 in recent months.

But the study concluded that the sharp jump in OPUC remains “something of a puzzle.” The researchers determined that concern about repurchases should not be much of a factor, perhaps only worth about $0.19 per $100 of loan, since buybacks should be much lower on the books of business originated in recent years.

Lower values for mortgage servicing rights are part of the answer, reducing a lender’s OPUC by about $0.60, the study found. Increased pipeline hedging costs stemming from somewhat longer application processing times may account for $0.12, and an increase in loan production expenses likely are another factor.

Capacity Constraints?

But the Fed researchers concluded that capacity constraints are likely a factor, although processing slowdowns have occurred in past origination spikes without increasing OPUC. Moreover, processing times weren’t much longer in late 2012 than they were in early 2009, before originator profitability began to soar.

Recent trends in the agency mortgage securities market suggest that capacity may not be much of a problem for many firms. Lenders increased their sales to Fannie Mae and Freddie Mac by a whopping 57 percent in November as they ramped up deliveries before a 10 basis point hike in guaranty fees went into effect last month. In December, sales fell back by 44 percent.

“A better potential explanation for why originators would make larger profits now than in the past would be that they may enjoy more pricing power than in the past on some of their borrowers,” the Fed paper said.

That may be especially true in the HARP program, which generated record business during the third quarter and borrowers are still somewhat at the mercy of their current servicer. Average coupons on high loan-to-value HARP loans were 40 to 50 basis points higher than similar non-HARP loans, a lot of that excess spread is captured by the lender, the study noted.

Similar trends may be at work in Fannie Mae and Freddie Mac streamlined refi programs for non-HARP loans, the researchers noted.

Fitch Ratings has a somewhat simpler view. Refinance activity will slow down in 2013 and that means the current levels of mortgage banking profitability are not sustainable.

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